With the ever-increasing costs of tuition, room and board, many families are interested in starting a savings program for college expenses. Although it is possible to use a conventional savings or money market account for this purpose, a wide variety of educational funding alternatives have been developed. These alternatives fall into four categories: (1) UGMA/UTMA Accounts (Uniform Gifts to Minors Act/Uniform Transfers to Minors Act), (2) Client Assets, (3) ‘529’ College Investing Plans, and (4) Education IRA's. Of course, these categories are not mutually exclusive: it is possible for the investor to allocate assets to a plurality of funding alternatives, such as an Education IRA and a UGMA/UTMA Account.
Client Assets include any financial assets that are owned by the client, such as savings or money market accounts, stocks, bonds and various other financial instruments. This asset category provides the investor with a significant amount of flexibility. Although the client may refer to these assets as part of a “college fund”, there are typically no legal restraints or incentives that limit disbursement of the funds to meet educational expenses. If the prospective student decides not to attend an institution of higher learning, if a financial emergency arises, or if the asset donor has a “falling out” with the child, the assets can readily be used for non-educational purposes, or transferred to a third party. the assets can readily be used for non-educational purposes, or transferred to a third party. Unfortunately, this flexibility comes at a price: any investment income will be taxed according to the client's ordinary income and/or capital gains tax rate.
Funds held in UGMA/UTMA accounts are controlled by a custodian until the child reaches the age of majority. These accounts are advantageous in that investment income is taxed at the childs' rate, which is typically lower than the custodian's rate. Additionally, the gift may qualify for the annual gift tax exclusion. Moreover, if the gift involves property, once the property is sold, the gain is taxable at a special, lower rate. UGMA/UTMA accounts do present several shortcomings. The client no longer controls the assets. Worse yet, the child owns the funds and, upon reaching the age of majority, can use them for any purpose whatsoever. Depending upon the age of the beneficiary, gifts made to a UGMA/UTMA account by the custodian of the account could be included in the custodian's estate for tax purposes. The child's ability to qualify for financial aid may be adversely impacted. Finally, income generated from assets that are owned by a child are subject to special income tax considerations. These considerations are a function of the child's age and income. If the proper conditions are not met, the investment income could be taxed at the parent's (usually higher) rate.
‘529’ College Investing Plans are relatively new savings vehicles that are becoming increasingly popular. These plans offer tax-advantaged saving and investing while, at the same time, providing the client with some control over fund distribution. Federal taxes are deferred until the funds are distributed, when growth in excess of contributions is taxed at the child's rate. Funds may grow free of state income taxes, depending upon the laws in the state(s) where the client files a state income tax return. Assets can be used to pay for tuition, room, board, books, and required supplies at any accredited post-secondary school in the United States. Contributions are generally considered as having been removed from the client's taxable estate. Married couple filing jointly can contribute up to $100,000 in a single year without gift tax consequences, provided that no more gifts are made to the beneficiary for a five year period. Single taxpayers can contribute up to $50,000 in a single year.
A fundamental advantage of ‘529’ College Investing Plans is that the participant retains control of the account. Moreover, the participant can change beneficiaries at any time, as long as the new beneficiary is in the same family as the original beneficiary, without incurring a penalty. Although non-qualified withdrawals can be made at any time, the participant must pay a penalty on earnings. Earnings from non-qualified withdrawals are taxed as ordinary income at the participant's rate. However, the participant may make penalty-free withdrawals if the beneficiary receives a scholarship, or in the event that the beneficiary dies or becomes disabled. There are no annual income limits on participation, no annual filing requirements (unless a withdrawal has been made), and substantially no time limits for which assets must be held in the plan.
For many individuals, the ‘529’ plans represent a significant improvement over previously-existing college investment vehicles. However, these plans are not without their shortcomings. Once funds are contributed to the plan, the participant does not control the manner in which the funds are invested. Investment decisions are typically made by fund managers who are hired by the sponsoring state. It is only possible to make contributions to '529 plans in the form of cash. Securities cannot be transferred into the plan. Of some significance, the funds can only be used for educational purposes to receive full income tax benefits. If funds are withdrawn for other than educational purposes, the earnings portion is taxed as ordinary income, and a 10% penalty is assessed.
It is possible to combine a '529 plan with a UGMA/UTMA transfer, so as to enable a client to benefit from the tax advantages of both funding alternatives. Monthly contributions are made to a UGMA/UTMA fund until the investment income generated within the account exceeds the tax-exempt limit of $700 per annum. Any further contributions are then made to a '529 college investment plan to take advantage of tax-deferred growth.
One last category of education investment alternatives is an Education IRA. This IRA allows annual, non-deductible contributions up to $500 per annum until the beneficiary reaches the age of 18. IRA contributions grow tax-free. Withdrawals are tax-free if they are used for qualifying educational expenses. Unused funds may be transferred to other family members, but only if the funds are then used for educational purposes. Anyone, including grandparents, may contribute to an education IRA. However, contributions from all sources may not exceed $500 per beneficiary per year. Eligibility is based upon the contributor's modified adjusted gross income, and phaseout starts when this income exceeds $150,000 for married contributors and $95,000 for singles. In general, assets must be distributed by the time the beneficiary reaches the age of 30.
From the foregoing summary of various college investment plans, it is apparent that potential contributors are confronted by an almost bewildering array of options. It may be difficult or impossible for the average contributor to determine which plan is best for a given situation. In an effort to provide some guidance to these contributors, a number of web sites have been developed which permit investors to assess the pros and cons of a specific college investment plan. Such web sites differ greatly in terms of the financial calculation program(s) that are used, the inputs that may be entered into these programs, and the outputs that are provided.
Irrespective of the manner in which a given college investment web site is implemented, existing financial calculation programs do not consider the tax implications of various funding alternatives for the contributor and the child. These considerations are significant factors in determining which investment plan or plans are best suited to the needs and circumstances of specific investors. If tax considerations are ignored, an inappropriate or suboptimal college investment vehicle may be selected.
Many existing college investment web sites are affiliated with state-administered '529 college investment plans. These plans are sometimes referred to as Qualified State Tuition Programs. One of the most advanced web sites is operated by the New York State College Choice Tuition Savings Program (URL: http://www.nvsaves.com). This site includes a calculation program that accepts a child's current age, college start date, current college savings, annual savings after tax rate of return, and estimated annual tuition. The program outputs a year-by-year savings chart and a college savings graph. However, the savings charts and graphs do not compare one college investment plan with another. Moreover, the tax consequences of the investments are not considered. The program accepts an input in the form of an after-tax rate of return, whereas the contributor may not be able to determine this rate with any degree of ease and certainty, or may simply not wish to calculate this rate by performing a series of tedious mathematical calculations. Also, the contributor may wish to obtain information related to the manner in which this rate of return could be maximized, instead of merely entering an estimated value as a fixed input to the financial calculation program.
Another exemplary college investment web site is operated by a company known as “TIAA-CREF”. The site utilizes a “college savings calculator” that accepts the prospective student's current age, age at which the student will start college, current college savings, monthly savings contribution, current tuition cost, estimated annual tuition inflation, and annual after-tax return on savings. In response to these inputs, the program calculates the projected year-to-year increase in college savings balance, as well as an inflation-adjusted tuition goal. A graph is displayed to show how far a contributor's projected savings balance will go toward covering tuition costs over four full years of college attendance. Of significance, the calculations are based upon after-tax rate of returns. Accordingly, the contributor is left with the task of assessing the tax ramifications of an investment option. These ramifications may have a significant financial impact on the efficacy of the savings plan in meeting educational expenses. Moreover, the program does not provide a comparison among various investment options.
Yet another college investment web site is operated by Fidelity Investments. This site provides a qualitative “comparison table” that lists the basic advantages and disadvantages of various college funding alternatives. However, it is important to realize that this table does not show the results of any financial calculation, nor does it contain any user-specific information. Rather, the table includes a list of predetermined textual messages. The Fidelity Investments site does offer a calculation program called a “college cost calculator, but this calculator is not tied to the comparison table. The calculator accepts inputs in the form of the child's age, years remaining until the child enters college, years of college planned, pre-tax rate of return, college inflation rate, and present annual college cost. The outputs are provided in numeric form, and include total college cost in today's dollars, total college cost in future dollars. Target savings amounts are provided, broken down into monthly, yearly, and quarterly increments. A one-time lump sum savings figure is also provided. As was the case with previously-mentioned sites, the calculator output does not take into account tax implications for the parent and the child. Nor does this output show any type of numerical comparison between different college funding alternatives.
In view of the foregoing web site analysis, there is a need for a college funding calculator that considers the tax implications of each of a plurality of college saving plans. There is also a need for a calculator that provides a comparative analysis for these saving plans, so as to enable an investor to select a plan or combination of plans that best meets his or her needs.